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Seed Weekly - The Shift to Passive Investing

When it comes to investment management trends, the US tends to lead the world. One trend that started as a trickle to become a raging river is the flow of investment funds away from active managers over to passive fund managers.

In his annual report for Berkshire Hathaway, Warren Buffett has over the past few years continued to endorse the idea of passive investing rather than active investment management. His advice is for investors to rather opt for a low cost S&P500 index fund (i.e. a passive index tracker).

The statistics are proving that in the US at any rate, investors have started to listen to him and others. Morningstar reported, “In the U.S., the gap between active and passive flows has never been wider. U.S. index funds received $492 billion in 2016. Their active counterparts, in sharp contrast, saw $204 billion fly out the door.”

So just what is passive and active?

A passive investment strategy is a fund or investment strategy that merely tries to replicate a certain index as closely as possible over time. Because the constituents and construction methodology of most indices, like the S&P500 index, are made available, a simple strategy is for a portfolio to exactly replicate this.

Active investment management, on the other hand, is a style of investing where the portfolio manager aims to design a portfolio that will outperform the fund’s benchmark or index. The selection of shares and the weight of the shares will therefore differ from the index in attempt to produce a superior result.

The pioneer of index investing in the US is Jack Bogle, founder of the Vanguard Group. This fund manager is now taking the lion’s share of money moving into the passive space. The chart below compares the flow of funds into active and passive strategies over the last 10 years.

Chart 1: Flow of Funds to Active and Passive Managers in the US

Source: Morningstar Direct, 22 March 2017

Multi management is the blending of both asset classes and specialist asset managers within one fund. Therefore, while we discussed the merits of diversification last week, an investor can obtain these benefits within one multi-asset, multi-management fund.

In our opinion, the rise of passive management merely provides more options to a multi-manager when looking to combine different investment assets, funds, and investment styles. A manager can combine the best of both worlds - passive strategies, which aim to extract merely the market return for an asset class at the lowest cost possible, with active strategies that aim to extract additional alpha (i.e. a return above the market).

Active and passive strategies will typically perform differently in different market cycles. Normally, in strong bull markets, as we have witnessed over the last 8 years in global equities, passive strategies will tend to outperform. However, in choppy and sideways markets, often characterised by sector rotation, good active managers will tend to produce superior results.

At the same time, passive strategies can be very specific. For example, on a global scale, there are passive index funds that only comprise healthcare shares, or only IT (information technology) shares. These can be used with great effect within a multi-manager portfolio.

At Seed Investments, we are very positive about the global availability, and increasingly so, local availability of passive investment strategies. The expanding choice is excellent where we are looking to blend different styles and investments with low correlations.